Methodological Study on Economic Statistics: Islamic Finance in the National Accounts

Transcription

1 E/ESCWA/SD/2017/Technical Paper.4 Economic and Social Commission for Western Asia (ESCWA) Methodological Study on Economic Statistics: Islamic Finance in the National Accounts United Nations Beirut

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3 iii Acknowledgements The present publication was prepared by the Statistics Division of the Economic and Social Commission for Western Asia (ESCWA). ESCWA and the United Nations Statistics Division organized the Workshop on Islamic Finance in National Accounts, held in Beirut from 24 to 26 October 2017, attended by regional and international organizations and 17 Arab, African and Asian countries. The present report contains the main papers presented at the workshop. The authors are Mr. Russell Krueger, retiree from the Statistics Department of the International Monetary Fund and consultant at the Islamic Financial Services Board; Mr. Ragheed al Moghrabi, financial expert and professor at Rafik Hariri University; Mr. Omar Hakouz, regional advisor on national accounts at the ESCWA Statistics Division; Ms. Wafa Aboul Hosn, Chief of the Economic Statistics Section of the Statistics Division at ESCWA; Mr. Herman Smith, Chief of the National Accounts Section at the United Nations Statistics Division; Mr. Besnson Sim, Statistician in the National Accounts Section at the United Nations Statistics Division; and Ms. Rima al Bizri, Chairperson of the Management Studies Department at Rafik Hariri University. The authors thank the participants at the workshop, who contributed with papers, discussion and knowledge-sharing: Mr. Mohammad Ibrahim Naimi from Afghanistan, Mr. Mohamad Shahabuddin Sarker from Bangladesh, Mr. Youssouf ibn Ali from Chad, Ms. Koto Ehou M'Boya from Côte d'ivoire, Ms. Amany Abdel Khalek Khalil from Egypt, Mr. Buyung Airlangga from Indonesia, Mr. Mahmoud Abdallah Mohammad Abudalou from Jordan, Ms. Mona Mohamed bin Ghaith from Kuwait, Mr. Mohd Yazid Kasim from Malaysia, Ms. Bouchra Farghsaoui from Morocco, Mr. Attiq-ur-Rehman from Pakistan, Ms. Amina Khasib from the State of Palestine, Mr. Homoud al Suare from Saudi Arabia, Ms. Sanaa Abdalla Omer Zaroug from the Sudan, Ms. Denise Sjahkit from Suriname, Ms. Solomy Bamanya from Uganda, Mr. Abd el Shafi el Ashmawy from the United Arab Emirates, Mr. Hamdi Ali Ibrahim al-shargabi from Yemen, Mr. Ibrahim Akoum from Ras al Khaimah Center for Statistics and Studies, Ms. Siew Koon Goh from the Bank for International Settlements, Mr. Aziz Gulomov from the Islamic Development Bank, Ms. Zehra Zumrut Selcuk from the Statistical, Economic and Social Research and Training Centre for Islamic Countries, and Mr. Alick Mjuma Nyasulu from the Statistical Institute for Asia and the Pacific.

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5 v Executive summary Islamic finance does not operate in the same way as conventional finance, as it follows sharia law, principles and rules. Sharia law does not permit the receipt and payment of riba (interest), gharar (excessive uncertainty), maysir (gambling), and short sales or financing activities that it considers harmful to society. Instead, parties must share the risks and rewards of a business transaction, which should have a real economic purpose without undue speculation and not involve exploitation of either party. A detailed description of how Islamic financial institutions operate under Islamic principles and how the instruments they use differ from conventional financial instruments is set out in Annex 4.3 of the Monetary and Financial Statistics Manual and Compilation Guide, 1 which describes the principal characteristics of financial assets and liabilities and their classification by type of financial instrument within the framework of monetary and financial statistics, in line with the 2008 System of National Accounts (SNA). However, issues regarding the implementation of the 2008 SNA recommendations for Islamic finance were raised at several meetings in the Arab region, organized by the United Nations Economic and Social Commission for Western Asia (ESCWA). The following two positions emerged: Position 1: Islamic banks produce financial intermediation services that should be indirectly measured, and should provide deposits and loans similar to conventional banks in line with the Monetary and Financial Statistics Manual and Compilation Guide. As such, research is needed on how to measure the input cost of trade arrangements in the case of markup (murabahah), and on how to interpret the management fees paid by depositors (investors) to the bank; Position 2: Islamic banks should not be seen as conventional banks, but rather as managers of mutual funds or non-money market funds. This would imply a different classification and recording of the financial instruments of Islamic banking. Methodological work has been undertaken by the United Nations Statistics Division (UNSD) and ESCWA on implementing 2008 SNA. Recommendations on Islamic finance were raised at several meetings in the Arab region organized by ESCWA, which presented a paper to the Advisory Expert Group on National Accounts at its tenth meeting held in Paris from 13 to 15 April The Advisory Expert Group agreed that further research on the statistical implications of Islamic finance for national accounts was required, and that practical guidance on the treatment of Islamic finance transactions needed to be developed. To this end, a task force on Islamic finance was established by UNSD and ESCWA to address the statistical treatment of Islamic finance in national accounts. A WebEx meeting of key stakeholders was held in June

6 vi 2017 to identify principal areas of work. An Islamic finance website has been set up to consolidate relevant material and provide updates. 3 A workshop on Islamic finance in national accounts was held in Beirut from 24 to 26 October Experts and representatives from different regions presented several papers, which are available on the meeting website. The present report contains the main papers presented at the workshop. The findings were presented at the 11th meeting of the Advisory Expert Group on National Accounts held in New York in December

7 vii Contents Page Acknowledgements Executive summary List of abbreviations iii v xi Paper One Islamic Finance in National Accounts by Russell Krueger xiii Abstract 1 Introduction: Islamic finance 1 Structure of conventional and Islamic bank accounts 3 Income statements 3 Balance sheets 5 Profit equalization reserve allocated to shareholders 6 Financial intermediation services indirectly measured for Islamic banks 6 Conventional banks 7 Islamic banks 8 Profit distribution to investment account holders 10 Background 10 Bank funding instruments 10 Treatment in the System of National Accounts and monetary statistics 14 Classification of Islamic finance institutional units 16 Islamic institutional units 16 Residency 17 Financial subsectors 18 Financial subsectors 19 Structural indicators of Islamic banking 25 Conclusion 27 Bibliography 29

8 viii Paper Two A Review and Treatment of Islamic Versus Conventional Bank Products in National Accounts by Ragheed al Moghrabi, Omar Hakouz and Wafa Aboul Hosn 31 Abstract 33 Background on differences in traditional versus Islamic platforms 33 Risk of specific products versus issues such as tenor and liquidity 41 Islamic products generating an interest-like return in the market: a competitive and transactional perspective 43 Short- to medium-term murabahah financing 43 Medium- to long-term ijarah financing 43 Home and real estate financing 44 Agency fees 44 Financing fees 45 Monetary aggregates and money supply measures 45 Classic money markets 45 Islamic money market instruments 46 International Financial Reporting Standards and Islamic finance 46 Time value of money within International Financial Reporting Standards 48 Evaluating income components for an Islamic institution 50 Risk management 54 Bibliography 56 Paper Three A Second Generation of Islamic Banks: Riding the New Wave Rima M. Bizri 57 Abstract 59 Background 59 The challenge 59 The new wave 60 The call 60 The question 60 Specialization is key 61 The proposal 61 Bibliography 61

9 ix Paper Four Key conclusions and recommendations of the Workshop on Islamic Finance in National Accounts, Beirut, October 2017 Benson Sim, Herman Smith, Omar Hakouz and Wafa Aboul Hosn 63 Introduction 65 Background 66 Discussions at Beirut workshop 67 Key conclusions 67 Relevance of the 2008 SNA framework 67 Use of income statements and balance sheets of Islamic banks 67 Sectorization of Islamic financial corporations 68 Classification of Islamic financial instruments 68 Classification of corresponding property income 68 Output and value added of Islamic financial services 69 International initiatives to collect data on Islamic finance 69 Way forward 69 Endnotes 71

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11 xi List of abbreviations AAOIFI ATM CPC ESCWA FISIM FSI GCC GDP IAH IAS IFE IFI IFP IFRS IFSB IFSI IMF IRR ISIC MENA Accounting and Auditing Organization for Islamic Financial Institutions automated teller machine Central Product Classification Economic and Social Commission for Western Asia financial intermediation services indirectly measured Financial Soundness Indicator Gulf Cooperation Council gross domestic product investment account holder International Accounting Standard Islamic finance entity Islamic financial institution Islamic financial product International Financial Reporting Standards Islamic Financial Services Board Islamic Financial Services Industry International Monetary Fund investment return reserve International Standard Industrial Classification of All Economic Activities Middle East and North Africa

12 xii MMMF NPL ODC OFI PER PIFI PLS PSIA PSIFI SDMX SDU SIFI SNA SPV SSU TBP UNSD money market mutual fund non-performing loan other depository corporation other financial intermediary profit equalization reserve Prudential Islamic Financial Indicator profit and loss sharing profit-sharing investment account (participation account) Prudential and Structural Islamic Financial Indicator Statistical Data and Metadata exchange savings deficit unit Structural Islamic Financial Indicator System of National Accounts special purpose vehicle savings surplus unit traditional bank product United Nations Statistics Division

13 xiii Paper One Islamic Finance in National Accounts by Russell Krueger Retired; Statistics Department at the Imnternational Monetary Fund; and Consultant for the Islamic Financial Services Board

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15 1 Abstract The 2008 System of National Accounts (SNA) does not provide guidance on methods to compile national account statistics for Islamic banking and finance. The present paper explores how Islamic finance should be handled in the 2008 SNA and monetary statistics. Important differences exist between conventional and Islamic finance, which must follow certain sharia legal standards. Topics discussed include the differing structure of conventional and Islamic bank accounts, financial intermediation services indirectly measured (FISIM) for Islamic banks, profit distributions by Islamic banks, the classification of Islamic finance institutional units, and structural indicators of Islamic banking. Introduction: Islamic finance Islamic banking and other forms of Islamic finance have developed rapidly over the past 50 years. Today, Islamic banking is found mainly in the Middle East, Asia and Africa, where it provides banking services mostly to Muslims and to several governments and central banks in countries where Islamic finance has official or semi-official status. Several international and regional organizations have recently become increasingly supportive of Islamic finance, reflected in steps such as bolstering supervisory oversight, building legal and market infrastructure, and issuing Islamic financial instruments to create more liquid markets and tap additional sources of capital. national financial systems. The 2008 SNA does not provide guidance to national compilers on methods to compile national account statistics for Islamic banking and finance. The present paper explores how Islamic finance should be handled in the 2008 SNA. Important differences exist between conventional and Islamic finance. Islamic finance is intended to serve as an ethical framework for economic and social justice that must follow certain sharia legal standards; - There are several schools of Islamic finance, but general principles include the following: Islamic finance in some countries is large enough to affect the quality of their national accounts, monetary and financial statistics, and indicators of the structure and soundness of Payment of interest or other fixed returns on investments is prohibited, which can also be interpreted as prohibition on financial

16 2 Investment in real economic activities or trading in goods and services for profit is encouraged; Profiting from trading in financial assets or avoided; Islamic banks have some types of deposit accounts, but they also are heavily funded by accounts in which returns or losses are shared between the bank and the depositor/investor that are called profit-sharing investment Those funding these accounts are described as investment account holders (IAHs); Excessive risk taking is discouraged, which is often interpreted as prohibiting many types of financial derivatives; Lending for certain activities, such as those involving alcohol or drugs, is prohibited; Sharing profits for charitable purposes (zakat) is a religious duty; Several methods exist to smooth returns to IAH that do not have equivalents in conventional banking; Sharia-compliant activities should be segregated from non-compliant activities and funds; Some Islamic financial instruments have names and financial flows that do not readily fit the standard SNA financial instrument classification. Owing to those practices, the financial accounts of Islamic banks (income statements and balance sheets) differ significantly from those of conventional banks. Separate sets of standards have been developed for Islamic finance, including accounting standards promulgated by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in Bahrain and bank supervisory standards by the Islamic Financial Services Board (IFSB) in Malaysia. Significant questions arise on how to translate data for Islamic banks into national accounts and monetary statistics. 6 The present paper seeks to translate several key elements of Islamic banking into SNA accounts for use in national accounts, monetary statistics and balance of payments, among others. Moreover, certain macroprudential issues are compared between Islamic finance and conventional finance, as promulgated by the Basel Committee on Banking Supervision and by the International Monetary Fund (IMF) and other key international institutions in their Financial Soundness Indicators (FSIs).

17 3 Structure of conventional and Islamic bank accounts This section compares the income statements and balance sheets of conventional and Islamic banks. There are important differences that affect the estimation of production of Islamic banks and FISIM, as will be discussed later. Income statements 1. Conventional banks The income statements of conventional banks (table 1) differ from those of non-financial core function as deposit-taking financial intermediaries in particular, income accounts are headlined by net interest income (interest receipts less interest payments). That is, the bank receives interest on its funds lent and pays interest on funds received from depositors. By lending funds, the bank acquires a claim (asset) on the borrower for repayment of the amount lent plus interest. By receiving funds from the depositor, the bank incurs an obligation (liability) to repay the deposited funds plus interest. The income statement of a conventional bank typically shows net interest as a separate line item at the top of the accounts. That is, the top lines separately list interest receipts, interest payments, and net interest receipts less payments (which is core information for FISIM accounts). 7 Other revenue for banks (typically called non-interest income) is shown below the net interest line. The sum of net interest and non-interest income is the gross income of the bank. Other expenses are subtracted from gross income to derive income before income taxes, which can also be thought of as net operating income. Expenses consist of non-interest expenses (salaries, office expenses, utilities, and others) and provisions for loan losses. Taxes on income are subtracted from net operating income to derive net income. Dividends are paid from net income, leaving retained earnings which are then carried over to the balance sheet as part of equity. Table 1. Representative income statement of a conventional bank Revenue Total revenues Net interest income Interest income Interest expenses Non-interest income Expense Total expense Non-interest expense Provisions for loan loss Income Income before income tax (operating income) Income tax Net income Dividends Retained earnings

18 4 2. Islamic bank The income accounts of Islamic banks (table 2) 8 differ in the following ways from those of conventional banks: Islamic banks raise funds through deposits and through funding from depositors/investors (IAHs). 9 Islamic banks have quasi-equity obligations to IAHs in contrast to the liability of conventional banks to repay depositors; 10 Islamic banks manage funds received to produce returns through investments or financing of transactions for customers: banks from IAHs are commingled with other bank funds in the same way as deposits in conventional banks; separately by the bank and segregated from funds received from other IAHs. They have some characteristics of asset management accounts that, due to recent changes in accounting standards, might or might not be treated off balance sheet; The returns to Islamic banks on their financing and investment are not guaranteed, but depend on the success or failure of their ventures. Returns (and sometimes losses) are divided between the bank and IAHs based on the specific types of Islamic financial instruments used; Diverse financial instruments are used that earn revenues in different ways, such as financing of sales, leasing, fees, equity participation, or investment. Some instruments do not have conventional bank equivalents. Unlike conventional banking, there is no common interest rate (nor interest rate ladder) applicable to Since Islamic banks do not receive or pay interest, the net interest section in the accounts of conventional banks is replaced which is a rather complex calculation of net revenues (revenues less associated costs) 12 earned on funds managed by the bank (which can be comm own funds), and the distribution of the net revenues between the bank and IAH. In essence, it is a self-contained income statement covering the funds and returns of the bank vis-à-vis IAH. Funding accounts can be unrestricted or restricted. Unrestricted funds are commingled with funds of other investors and the bank in much the same way as conventional banks Restricted funds are managed separately based on agreements between the investor and the bank. The working assumption is that the assets are managed off balance sheet 13 and only the bank share in restricted A profit equalization reserve (PER) can be used to smooth returns paid to IAHs. PER is treated as income of IAHs, but held back by the bank to make future payments to IAHs. as fees, commissions, revenues for services provided, currency trading and holding gains/losses, among others. Total gross income is the sum of revenue on jointly funded assets 11

19 5 and other revenues. Expenses are subtracted from gross income to calculate net income before taxes and zakat. Net income after taxes and zakat are calculated and divided between dividends to owners of the bank and retained earnings. At its discretion, an Islamic bank may create an investment return reserve (IRR) that Balance sheets The balance sheet of an Islamic bank closely parallels conventional balance sheets, but with the following three notable changes. Non-financial assets possible losses experienced by IAHs. Table 2. Representative income statement of an Islamic bank 1 2 Income 2i 2ii 2iii Revenue from jointly funded assets (net financing and investment income) 3 Other costs 4=2-3 Income from financing less financing costs Income from investments less investment costs less provisions for accrued income on nonperforming assets of which: transfer to profit equalization reserve (PER) Income available to unrestricted depositors/investors and bank less income distributed to unrestricted depositors/investors Bank share in restricted investment income Other income Fee-based income Other income Total gross income Expenses Salaries and other operating expenses Depreciation and other provisions Net income before taxes and zakat Taxes Zakat Net income after taxes and zakat Dividends Retained earnings Without a concept of interest earnings, Islamic financial instruments often generate income through sale or lease of underlying goods or services. The Islamic bank must have legal ownership of the underlying assets even if for only an instant, during which period the bank incurs all the risks and rewards of holding the asset. Those assets are reflected on the balance sheet -financial assets related to sales, lease linked to financial contracts with customers and thus could be volatile and different in behaviour from other non-financial assets, which should be non- - framework, but it is reco -financial assets The treatment of non-financial assets under contract has potential implications for SNA flow accounts, which are as follows: (a) Holding gains and losses: While under possession by the bank, the assets could experience holding gains or losses that should be recorded in the SNA revaluation account; (b) Regular income on the contract: A contract might specify the price for an underlying

20 6 good creating a net profit for the bank. Under the IFRS 15 regulating revenue from contracts with customers, the gain or loss on non-financial assets would be recorded as income using a five-step model as the conditions of the contract are met. Unfortunately, as a practical matter, it could be difficult to disentangle types of flows (trading gains, fees and holding gains) for SNA purposes; (c) AAOIFI recently launched a project to reexamine whether financial contracts with customers involving delivery of goods should go through an IFRS 15 review before being treated as a financial instrument there is no current information on which way the decision might go and the implications for the bank income statement and balance sheet. The present paper does not propose a solution for this situation until after this review is completed and more experience is gained. Profit equalization reserve allocated to shareholders Under a profit-sharing model, an Islamic bank can withhold part of the net profits of IAHs as part of a PER, which will be shown in equity Under SNA accrual rules, the net profits for IAHs (including the component transferred in PER) should be treated as distributed. The PER component is subsequently treated as a separate transaction to reinvest funds into the reserve. IAHs have equity ownership in the PER held by the bank, to be treated equity. Quasi-equity As per AAOIFI, returns to IAHs can be presented in a separate quasi-equity section shown below bank liabilities, but before equity. In contrast, IFRS treats such positions be classified based on their substance either as a liability or as equity, which is the recommended treatment for SNA. Whenever a country allocates quasi-equity for statistical purposes as either a liability or as equity, it should be clearly noted in metadata along with the rationale used for the allocation. This is informative for users of the statistics, and will also affect prudential ratios such as the degree of leverage. Financial intermediation services indirectly measured for Islamic banks The concept of FISIM for Islamic banks parallels that of conventional banks. FISIM is a component of the national account measure of the production of banks. Banks are viewed as intervening between parties with surplus funds and those needing funding. In a perfect market, with an economy-wide prevailing rate of return, those with surplus funds could deal directly with borrowers. Surplus units would be able to invest

21 7 for investments; conversely, those needing funds could borrow funds at the same rate. However, banks can offer services to both sides that they cannot do themselves. The services are the production of the banking sector. Both surplus units and borrowing units pay for the services provided by banks in various ways. Some services are purchased directly through fees or sales of services, but total production includes payments for services provided that they are embedded in interest rates and thus are not in the form of fees. FISIM focuses on the implicit non-fee payments for bank services. For conventional banks, these payments are viewed as embodied in interest flows. However, FISIM as a measure of production is not limited to interest, thus services provided by conventional or Islamic banks that are not explicitly charged also are included. Consequently, the FISIM core concept as expressed in the 2008 SNA applies to both conventional and Islamic banks. In 2008 SNA, FISIM is calculated only on loan and deposit-like instruments handled by banks and similar financial institutions. For Islamic banks, the equivalent terms are financing and funding. It cannot be assumed that the amount of financing offered directly corresponds to an equivalent amount of funding; therefore, the FISIM formula is applied independently to each side of the ledger then summed to obtain the total production of the banks. Conventional banks Production on the lending side is measured as interest receipts in excess of the market rate of In a conventional bank, the borrower pays an interest rate greater than the prevailing market rate of return, with the difference representing services provided by the bank. For depositors, receipts of interest less than the prevailing market rate of return (foregone interest) are implicit payments for services provided by the bank. For an Islamic bank, the rationale is fully equivalent, but returns on jointly-funded assets take the place of interest receipts and distributions of profits to depositor/investors take the place of payments of interest to depositors. Unlike conventional banks, the receipts and payments are not guaranteed, but depend on the results of the various ventures and investments made by the bank. Implicit services to borrowers = (rl rr) Loans rl = interest rate charged on loans rr = reference rate Similarly, on the deposit side, production is measured as interest foregone; that is, interest paid less than the reference rate. Implicit services to depositors = (rr rd) Deposits rr = reference rate rd = interest rate paid on deposits FISIM = Implicit services to borrowers + Implicit services to depositors = (rl rr) Loans + (rr rd) Deposits

22 8 Islamic banks A parallel formula can be constructed for Islamic interest rate charged on loans, and istribution of profits to depositor/investors substitutes for interest paid to depositors. The market rate of return, rr, is the same. 14 Implicit services embedded in financings = (rfin rr) Financing Implicit services to IAH = (rr rfund) Funding rr = reference rate rfin = return on financings rfund = profit distributions on fundings for conventional banks, and an instrument-byinstrument approach. 1. Broad approach A broad approach recognizes that for many Islamic bank customers, the bank serves as a straightforward depository institution in which funds of many customers are placed in a common deposit account and may or may not pay returns depending on the type of account chosen (namely, return generating, or nonreturn generating current accounts or for safekeeping). The Beirut workshop revealed that something similar to the broad approach is used in most participating countries. Once total FISIM is estimated, purchases of the services by each sector must be calculated based on the amount of loans and deposits by each sector. 15 The distribution can change gross domestic product (GDP) and intermediate costs of each sector. For example, an interest payment by a corporation to a bank is an intermediate cost to the corporation, but a payment for implicit services by a non-resident is a final purchase that directly increases GDP. The application of the formula to Islamic banks is more complex than for conventional banks because of the diversity of instruments used. However, this might be mitigated because in Islamic banking the bank and the unit providing funds typically co-invest in the profit making venture, and thus must document the profits earned and the distributions paid. Two strategies can be employed, namely, a broad approach that parallels the calculations Under the broad approach, total FISIM equals the difference between revenue on jointlyfunded assets and payments to IAHs (sum of funds transferred to PER and distributions available to IAHs from jointly funded accounts). In table 3, FISIM equals line 1 less the sum of lines 7 and 9. Table 3. Islamic bank income distributable to IAH 1 Revenue from jointly funded assets 2 By type of income 3 less provisions for accrued income on nonperforming assets 4 Financing and non-financing costs 5 Provisions for substandard or bad financing 6 Other costs 7 Transfer to PER 8 Income available to unrestricted IAHs and bank 9 Income distributable to IAHs

23 9 Line 1 represents the income received on financing, broadly equivalent to interest earnings of conventional banks. Lines 2 through 6 represent costs to banks to administer the financing operations, but do not include an equivalent for interest expenses. Income payable to depositors/iahs (equivalent to interest expense of conventional banks) equals the sum of lines 7 (transfer to PER) and 9 (income distributable to IAHs). Line 7 represents current earnings of IAHs withheld from immediate payment by placing them in a reserve used to smooth future payments to IAHs if future revenues fall. On the SNA accrual basis, the current transfers of earnings into PER are treated as an income payment followed by reinvestment into PER, creating an IAH financial claim on the bank. 16 Line 9 represents the actual payments to IAHs. The distribution of FISIM by economic sector is based on the sectoral distribution of financing provided by the bank and funding of the bank, parallel to the calculation for conventional banks. There is no direct information from this calculation about the reference rate (rr) to be used in the calculation, and thus an economywide rate would need to be applied. Absent any more specific information, the midpoint between the average rate of return on financings and average rate of payments on funding might be used, which was found to be a common practice in countries attending the Beirut workshop Instrument-by-instrument approach This approach recognizes that there is no simple interest-rate-type calculation to estimate income earned by a the type of returns paid to bank customers and the distribution of returns between the bank and customers can vary greatly depending on the type of Islamic financial instrument used. In lieu of interest, Islamic financial instruments earn returns based on various investment strategies, namely, financing of sales, leases, fees, equities or investment. Moreover, the distribution of returns between a bank and its customers varies by instrument and the negotiated distribution of shares between a bank and its customers. This approach can be more precise in identifying service-like payments on Islamic financial instruments versus returns-oninvestment vehicles for which a bank takes a management fee. It also allows construction of more accurate rate-of-return information. Islamic banks must track the returns for depositors and investors by instrument to remunerate their funders. 18 How much of this detail is available to supervisors or statisticians is unknown and could vary greatly by country it might not be a feasible approach in some countries. This approach will become more feasible as standardization of instruments and terminology increases across countries something that is beginning to be seriously addressed, and which is likely to be included among the recommendations from the Beirut workshop.

24 10 Profit distribution to investment account holders This section discusses the financial instruments used by Islamic banks to make payments to IAHs. Information on types of Islamic financial instruments is provided as guidance on how they might be used in the instrument-by-instrument approach described above. The remuneration situation is complex and statistical calculations of rates of payment can be challenging, but is has been concluded that remuneration on some instruments (especially instruments based on financing of sales) has parallels to interest payments by conventional banks that allows estimation of rate-of-return type calculations suitable for FISIM calculations, but some instruments offer investment-like returns or generate explicit fee returns for banks that should be excluded from FISIM calculations. This section concludes that a nuanced treatment is possible, in which some types of Islamic bank payments to IAHs could have parallel treatment to interest flows, but a broader concept than interest is tentati intended to be a distinctly broader concept description of the returns to Islamic financial instruments. Background The rationale to exclude payments by Islamic banks as interest stems from a religious prohibition of interest, based on a dictum that money is only a means of exchange that does not have value except when used productively in investment. Money should not be hoarded nor used to gain more money. In contrast, productive use of money benefits investors and society as a whole. Thus, the use of money in a loan or deposit to earn more money with the passage of time is prohibited. By extension, any fixed obligatory payment of income on a deposit or loan is forbidden. Moreover, if only productive investments are permitted, returns on investments take the form of profits rather than interest. For such reasons, it can be argued that payments for investment account-like deposits at Islamic banks do not constitute interest. In contrast, it is argued that by applying economic definitions, there are conditions in which payments by Islamic banks on some funding accounts have parallel treatment to interest within an expanded concept of returns on deposits. Moreover, the specific characteristics of certain Islamic financial instruments result in payments flows very similar to interest payments on deposits for analytical and statistical purposes it is useful to treat these flows as similar to interest paid by conventional banks. Bank funding instruments Since Islamic banks are prohibited from accepting interest-paying deposits, they raise funds through a variety of methods. Depositors/funders of Islamic banks participate in specific Islamic financial instruments that

25 11 generate income in diverse ways the remuneration paid to funders is affected by the interplay between the type of funding account chosen and the specific financing instruments used by the bank. Funders have the following choices: use pure deposit accounts that are not permitted to pay any return; use PSIAs that share income and losses between depositors and the bank; participate in various sales-based or lease-based financing instruments that can provide fixed repayment flows in the future; or participate in equity ventures. Some Islamic financial instruments have payment flows and characteristics similar to deposits and interest payments in conventional banks. 1. True deposits Amanah deposits (Wadiah in Malaysia) are safekeeping or current-account deposits that may not remunerate the depositor. They are based on the principle of safekeeping in trust. The bank is obligated to repay the deposit and cannot promise to pay any profit return. 19 The bank treats the deposit as an obligation and thus has an unambiguous liability for statistical purposes. Since repayment is guaranteed, amanah deposits are often used for savings, operating accounts and current accounts. They are therefore similar to non-compensated demand deposits placed at banks for safekeeping and for other banking services, such as checking and accounting. Without question, they constitute FISIM-type services provided by the bank. 2. Profit-sharing investment accounts PSIAs commingle funds of investors/depositors income by making productive investments. 20 The income is shared between IAHs and IFIs as agreed when the investment is made. IAH investments are not guaranteed and losses can result. The two most commonly used instruments for PSIAs are mudarabah and musharakah. Restricted PSIAs segregate accounts of individual IAHs. An IFI provides asset management investment services, might coinvest as an independent partner, and receives fee income in exchange for its services and expertise. The investor in the restricted PSIAs receives returns based on the type of financial instrument used. Unrestricted PSIAs commingle IAH funds with each other and with IFI funds, in the same way as conventional banks handle deposits. Returns paid to IAHs come from the general earnings of Islamic banks, like any financial institution, must offer competitive returns to attract funds. This applies both to the initial offer of a return to attract new funds, but also to actual payments experience over time that can provide confidence to future investors that the bank can produce adequate returns. It is generally held that Islamic banks must offer at least the general market deposit interest rate plus a small premium because of the risk of loss with PSIA.

26 12 The initial offer rate for an unrestricted PSIA must meet multiple conditions: a competitive rate, inability to make promises of specific returns, and legal/ethical requirements to not misrepresent likely returns. This is done by citing an that describes a rate that might be achieved but cannot be promised. 21 The income generated and eligible for distribution to depositors is more complex. In a conventional bank, the overall rate of return of the enterprise can be calculated, with interest paid on deposits treated as an expense. In an Islamic bank, the returns to IAHs and the bank are a form of profits. The share earned by depositors needs to be calculated. A variety of financial instruments with different returns, obligations, and fees can be involved, each of which can affect the division of returns between IAH and IFI. In cases where funds are effectively fully commingled, a rate of profit might be attributed each month to all IAHs outstanding; The distribution of income can be affected by several alternative methods to smooth the flow of payments back to depositors, as follows: For competitive reasons, IFI owners can forgo part of their own share of profits to smooth returns to IAHs. This is called. This can be done directly out of profits (which has been found to be a common form of smoothing) or might be mitigated by drawing funds from special types of reserves created for smoothing purposes; The PER sets aside profits for distribution to IAHs to smooth the returns paid. Funds are set aside from investment profits profits and the distribution between IAHs and shareholders (IFSB, 2010). 22 Because PER is allocated before deducting the IFI share, it in effect has a superior status; The IRR is set up from the net income of IAHs to avoid investment losses to IAHs. Funding for IRR is calculated after deducting IFI profit share, and thus it is solely owned by IAHs. It is typically used to cover losses to IAH capital and not to smooth profits. Sundararajan (2006) found that the degree of profit sharing is actually quite limited that is, returns to depositors are quite stable, as if they emulated payments of interest. His evidence supporting this view included: lack of correlation between returns paid to IAHs and overall IFI profits; and a significant positive correlation between returns to IAHs and the general market rate of return on deposits. Islamic banks therefore appear to extensively use the smoothing techniques available to even out payments to IAHs. Effectively, this results, in most cases, in a pattern of profit payments back to IAHs similar to payments of interest on deposits by conventional banks. 23 It should be possible to empirically test how closely profit payments to IAHs correlate with interest payments on conventional deposits. 3. Other types of deposits (a) Wakalah In wakalah, a bank acts as an agent for investment of depositors funds in exchange for

27 13 a fee, usually in the 1.5 to 2 per cent range. Potential depositors are offered an indicative return, but if the actual return is lower, the depositor receives only the actual return. Conversely, if the actual return is higher, the bank pays only the indicative return and keeps. Given the possibility of the bank earning this incentive, it will often not charge a fee. For potential depositors, there is a prospect of receiving an advertised return without paying fees because the bank presumably has incentives to earn more than the advertised return. There is also the possibility that depositors might receive returns less than advertised, but in this case the bank can voluntarily choose to make up the difference out of its own profits. In this case of wakalah, the returns actually paid to depositors have the essential characteristics parallel to interest paid by conventional banks. The returns should be based on the actual payments, including contributions from PER and IRR, among others. (b) Murabahah Murabahah is a sales contract in which an underlying commodity or service is sold against instalment - includes the cost of the underlying item plus a pre-agreed profit. Murabahah was originally designed as a trade instrument, but has been adapted to substitute a bank for the trading partner selling the underlying goods. Murabahah is the most common financing instrument, but is also used on the funding side. Instalment payments i, such as certifying, holding, transporting or delivering the underlying item; the embedded profit is not considered as a form of interest payment as a return for the monetary value of the underlying item. However, for statistical purposes, the embedded profit has an implicit rate of return that can be treated similar to interest in conventional banks and is suitable for FISIM estimates. (c) Commodity murabahah Commodity murabahah is a variation of the basic murabahah instrument in which IAHs deposit funds at a bank for purchase and resale of commodities, 24 but with cash flows that fund the bank, with funds to be repaid to IAHs in instalments with an additional embedded profit for IAHs. In particular, the purchase and resale of a commodity is included in the transaction, but this is handled instantaneously which allows IAH funds to be retained by the bank and used for its own purposes. That funding will be repaid to IAHs in instalments that include embedded profit payments. The deferred payment of profit has an implicit rate of return similar to interest in conventional banks. A bank has use of the funds during the life of the contract, thus funding the bank. Since it is a sale-based transaction, the deposit and the return can be promised up-front and guaranteed that is, they constitute bank liabilities. Commodity murabahat are linked to an underlying commodity transaction, which precludes its use for current accounts, operating

28 14 accounts or savings accounts. 25 Therefore, they are not suitable for small deposits and withdrawals, or for partial withdrawals through ATMs or web-based transactions. It is possible to convert the payment flows into a fixed rate equivalent. For example, if cash of $5,000 placed at the bank is repaid to depositors after one year for $5,200, the profit of $200 is equivalent to a 4 per cent return. Since the deposit amount and profit are effectively guaranteed, it has the same liability-based payment flows as interest-paying deposits at conventional banks. Treatment in the System of National Accounts and monetary statistics 1. Restricted profit-sharing investment accounts Restricted PSIAs appear to be primarily investment vehicles, with returns linked to specific investment agreements between IAHs and Islamic banks. Restricted accounts are often used by sophisticated investors (such as Islamic insurance companies or mutual funds) that understand and accept the inherent investmenttype risks. investment profits, and not parallel to interest. 27 However, in 2015, the AAOIFI Financial Accounting Statement 27 Investment Accounts ruled that mudarabah accounts in restricted control of the accounts. 28 The profit returns on these restricted PSIAs can be treated as parallel to interest, as can be done with profits on unrestricted PSIAs, as described below. 2. Unrestricted profit-sharing investment accounts (a) New deposits For sales-based transactions, data on the actual rate of return for new deposits can be used. This rate is pre-agreed between the bank and IAH at the time of the contract. For new PSIA deposits, the indicative rate offered can be used as a measure of the expected return on deposits, parallel to treatment of interest by conventional banks. A change in terminology is recommended. In countries where relevant, a 29 Until the recent past, according to AAOIFI accounting standards, assets within restricted PSIAs were treated as off-balance sheet, and only the net bank share of the returns on the investment was reported on the bank income statement. 26 It is recommended that returns to restricted PSIAs that are not consolidated into (b) Existing deposits For sales based transactions, the actual rate of return paid on deposits can be used. For existing PSIA deposits, a measure of actual payments is needed, calculated by actual payments divided by total deposits, or by

29 15 weighting rates of payments by type of deposit by their outstanding amounts. With reference to table 3, the payment streams distributed to IAHs, subject to reinvestment in a transfer to amounts out of current accrued IAH income transferred into reserves). In contrast, on a cash basis, actual payments to IAH can be increased by drawing on PER or IRR reserves built up from earlier returns. The funds withdrawn were previously recorded in the SNA as part of current income, and thus withdrawals should be recorded as transaction in financial assets that make payment, which reduces the IAH claim on the bank. Table 4. Types of financing instruments used by Islamic banks Instrument 1 Murabahah 2 Commodity murabahah/tawwaruq 3 Salam 4 Istisna 5 Ijarah/ijarah muntahia bittamleek Type of income generated Sales contract, embedded profit Sales contract, embedded profit Sales contract, embedded profit Sales contract, embedded profit Leasing/leasing with delivery 6 Mudarabah Profit/loss sharing 7 Musharakah Partnership 8 Diminishing musharakah Partnership 9 Wakalah Fee 10 Qard al hasan Non-remunerated benevolent loan 3. Terminology Source: Indicator ST07 contract. Value of financing by type of sharia-compliant The discussion above has identified several types of Islamic financial instruments that produce financial flows analogous to interest flows on bank deposits, but it is misleading to refer to the flows as interest for the numerous reasons covered above. It is suggested to use the SNA and monetary statistics. 4. Financing instruments Similar rationales can be applied to financing instruments used by Islamic banks. Table 4 lists major types of financing instruments used by Islamic banks, drawn from the PSIFI survey entitled Value of financing by 30 type of sharia- Among these instruments, items 1 through 4 are sales-based instruments in which predefined profits are embedded in instalment payments. Item 5 is a leasing instrument with predefined profits built into the lease payments. For all these instruments, rates of return can be calculated and treated as similar to interest returns. Item 6 shares gains/losses between the bank and its customer. As noted above in the discussion on unrestricted PSIAs, these are investment contracts that often provide smoothed profit returns to investors similar to interest earnings. It is an empirical question as to what type of return will be experienced in any particular country.

30 16 Items 7 and 8 are true partnership instruments where investors are fully exposed to volatile investment-like returns. Item 9 is a fee-based instrument, in which the party providing funds to a bank pays a fee for the bank to manage the funds. A fee of 2 per cent of managed funds is typical. The fee provides direct information on production of the bank. Item 10 is a benevolent loan made for social, welfare, or religious purposes that cannot receive any profit or other return. 5. Conclusion Many Islamic financial instruments have returns with explicit embedded profits, or that make smoothed payments that are functionally indistinguishable from interest payments by conventional banks. It is proposed that certain Islamic bank payments to IAHs could have parallel treatment to interest flows, but should similar invest to be a related but distinctly broader concept description of the returns on Islamic financial instruments. Estimates of flows and rates on interest and similar investment returns can be commingled within the SNA and monetary statistics. 31 But given their special nature, separate information should be provided on applicable returns on Islamic financial instruments, with notes regarding their distinctive nature. Classification of Islamic finance institutional units This section looks into types of Islamic finance institutional units and their sectoral classification. The 2008 SNA rules remain broadly applicable. This section focusses on how the SNA framework could specifically apply to Islamic financial units. Islamic institutional units a range of activities. Each institutional unit has a primary activity which is its most important activity. In addition, they can have one or more secondary activities. For example, an Islamic bank with primary activity in retail banking and secondary activities in insurance or selling information technology and bookkeeping services is classified as a bank based on the primary activity. Institutional units are the basic building blocks of the SNA system. They are entities capable in their own right of owning assets, incurring liabilities, making decisions, engaging in economic activities with other parties, and having financial accounts. They can engage in Common types of Islamic banking units include the following: Islamic banks domiciled in a country: An Islamic bank can be organized as a standalone bank, a subsidiary of a foreign

31 17 bank, a branch of a foreign bank, an Islamic window of a conventional bank, or a microfinance operation. In principle, each of these should prepare a single consolidated report of its domestic economic activity; Islamic windows of a conventional bank: Conventional banks often organize their Islamic financial activities in a separate sub-unit (subsidiary, branch, division, office, or others). For sharia-compliance reasons, different types of economic flows, customer preferences, different regulatory and policy regimes, and different financial accounting standards motivate segregation of the conventional and Islamic banking activities as materially different entities. Ideally, windows should be treated as virtual separate institutional units deconsolidated from their parent banks for various statistical purposes. For example, the PSIFI programme requests separate reporting of windows deconsolidated from the parent conventional bank; 32 Islamic microfinance units: Given their small size and limited record-keeping, treatment of individual microfinance operations as separate institutional units might be impractical, and thus consideration should be given to using surveys or statistical separated from their parent and treated in their own right as financial institutional units. Residency In national accounts, Islamic financial institutional units should be classified as resident or non-resident using the 2008 SNA standards. 33 istical framework covers country; transactions or positions of other - activity. SNA defines the economic boundaries of countries (which can differ slightly from the political boundaries) to determine whether an economic activity is resident or non-resident. The SNAapproach applies to all Islamic institutional units, whatever their legal organization. Transactions and financial positions of the domestic Islamic units with their foreign parents or with their own foreign subsidiaries or branches are treated as non-residents. Islamic banks are residents of the country in institutional subsector covering all operations in a country; Various other financial institutions such as holding companies, ancillary corporations, or special purpose vehicles (structured entities) captive to a foreign Islamic bank: As per 2008 SNA, which created several new financial institution subsectors, such units might be operate and intend to carry out economic activity for a year or more. For financial institutions, this is usually the country in which they register and are supervised. At this time, most Islamic banks operate in and are residents of only a single country and thus follow the domestic consolidation approach.

32 18 Box 1. Cross-border consolidations for soundness indicators for Islamic banks For macroprudential indicators of the soundness or vulnerabilities of Islamic banks, a cross-border data consolidation is sometimes used. Prudential data is often drawn from supervisory reports that consolidate activities across countries based on the residency of the parent bank in a banking group. Countries compiling the Prudential and Structural Islamic Financial Indicators (PSIFIs) promulgated by the Islamic Financial Services Board use a variety of residency standards based on supervisory requirements. Data consolidation based on international financial accounting standards and supervisory reports often use a cross-country (cross-border) consolidation basis. According to the Basel Committee on Banking Supervision, the parent bank of a multi-country banking group should prepare a single consolidated financial report covering itself and all its domestic and foreign subsidiaries and branches and other operations it might control. Moreover, in line with Basel II, subconsolidated financial reports can be required for each lower tier of subsidiaries, also on a cross-border basis. In cases where information is sought on total Islamic financial activity, such as for PSIFIs, a unique collection of resident Islamic banks and windows might be used that can include some non-resident operations within the consolidated accounts. This can be defined as an Islamic bank cross-border approach, which is a unique statistical consolidation structured as follows: The first component uses a domestically-controlled cross-border consolidation of Islamic banks headquartered or incorporated in a country, including relevant cross-border consolidation of lower-level units. This set of data corresponds to Basel requirements and is deemed to capture relevant information on the strengths and risks of a banking group, including risks arising in its foreign operations; A second component includes subsidiaries of foreign banks using a foreign-controlled cross-border consolidation. These units are supervised by authorities of their parent banks home countries, but are also legally organized in the host country and affect local financial conditions (of the country in which they are domiciled), and thus are also monitored and supervised by host country authorities; A third component covers branches of foreign banks in the country. Supervisors are increasingly imposing local capital and liquidity requirements on branches of foreign banks operating in their country, and are collecting more data to allow them to monitor their activities within the country. Source: Prepared by author. Financial subsectors Islamic banks are part of the financial sector, financial institutions are classified in the other financial subsectors (box 2). Financial corporations engage in financial activities and financial services for the market. Traditionally, financial activity was defined as engaging in financial intermediation, which involves raising funds on own account then investing or lending of funds to earn income. The 2008 SNA expanded the definition to

33 19 include financial risk management and liquidity transformation. This expanded financial activity in three ways: lending of funds on own account (which includes money lenders in developing economies) is recognized as a financial intermediation service; SPVs can be organized as financial entities classified as financial corporations; and ancillary (captive) financial corporations that provide financial services only to their parent corporation can be treated as financial entities classified based on the type of financial service provided. The financial sector of 2008 SNA has nine subdivisions. The expanded classification recognizes that various financial units play different roles that should be recognized, and that financing is increasingly supplied by nonbank financial institutions. Islamic banks are residents of the country in operate and intend to carry out economic activity for a year or more. For financial institutions, this is usually the country in which they register and are supervised. At this time, most Islamic banks operate in and are residents of only a single country and thus follow the domestic consolidation approach. Financial subsectors Islamic banks are part of the financial sector, financial institutions are classified in the other financial subsectors (box 2). Box 2. Financial corporations sector of a country; transactions or positions of other - external to domestic economic activity. SNA defines the economic boundaries of countries (which can differ slightly from the political boundaries) to determine whether an economic activity is resident or non-resident. The SNA-based omestic consolidation approach applies to all Islamic institutional units, whatever their legal organization. Transactions and financial positions of the domestic Islamic units with their foreign parents or with their own foreign subsidiaries or branches are treated as non-residents. Depository corporations: Central bank; Other depository corporations. Other financial corporations: Money market mutual funds; Other investment funds; Other financial intermediaries; Insurance; Pension funds; Captive financial institutions; Financial auxiliaries. Source: 2008 System of National Accounts.

34 20 Financial corporations engage in financial activities and financial services for the market. Traditionally, financial activity was defined as engaging in financial intermediation, which involves raising funds on own account then investing or lending of funds to earn income. The 2008 SNA expanded the definition to include financial risk management and liquidity transformation. This expanded financial activity in three ways: lending of funds on own account (which includes money lenders in developing economies) is recognized as a financial intermediation service; SPVs can be organized as financial entities classified as financial corporations; and ancillary (captive) financial corporations that provide financial services only to their parent corporation can be treated as financial entities classified based on the type of financial service provided. Financial corporations are divided into depository corporations and other financial corporations. 1. Depository corporations Depository corporations are the main monetary institutions in a country. They are divided into two subsectors, namely, the central bank, on the one hand, and other depository corporations (ODCs) that comprise banks and similar institutions, on the other. conducting monetary policy, and regulating the national banking system. In some countries, central banking functions are split between several institutions, but are treated as a single institutional unit. The 2008 SNA expanded the definition of the central bank to include supervisory organizations and financial supervisory authorities (including those of Islamic financial units) as core central bank functions. The central bank can also operate financial infrastructure for Islamic financial units (securities depositories, clearing operations, exchanges, and others), some of which could have significant financial assets. (b) Other depository corporations Banks (conventional and Islamic) are the core of the ODC subsector, which is central to a ODC is a financial intermediary with deposit liabilities or close substitutes for deposits that are classified as part of the national definition of broad money. 34 The Islamic banking subsector includes all Islamic banks and windows classified as ODCs under IMF definitions (which in effect treats unrestricted PSIAs as equivalent to retail deposits at conventional banks). Islamic banks (a) Central bank The central bank is the official monetary institution of a country with functions such as issuing currency, holding international reserves, conducting international financial policy, issue current account and safe keeping deposits, provide PSIAs to the public that functionally compete with conventional deposits, and carry out basic banking services by acting as intermediaries to accept funds from the public and extend financing. Islamic banks might also

35 21 be part of the official monetary policy system of a country and participate in interbank markets. 2. Investment funds Many types of investment funds exist. Money market mutual funds (MMMFs) are those with liabilities included within the national definition of broad money (for example, liabilities similar to transferrable and sight deposits at banks). All investment funds not classified as MMMFs are FSB has concluded that the best name for an Islamic Investment funds are collective arrangements that differ from fiduciary or custodial arrangements in which a manager acts as agent for an individual investor. Investment funds can be established as separate legal entities or on a contractual basis, but always have a set of accounts separate from entities that manage them. A firm might offer many different investment funds to attract different types of investors, but each fund is treated as a separate institutional unit because they will have different investors, pools of assets, investment strategies, liquidity, fee structures, and methods of distribution to investors. An investment fund receives and pools capital from investors who have equity shares in the common pool of assets, manages the funds to generate income (interest, trading profits and capital gains, among others), is compensated as the manager through service fees or portions of profits or other gains, and distributes the income or losses to the investors based on their shares. Investment funds can be an important alternative credit parallel those of banks, some offer share accounts similar to regular bank deposit accounts, and in some countries they can participate in official payments and deposit insurance facilities. Although investment funds can perform many banking type functions, they are often more flexible than banks in investment strategy and might offer higher returns because they do not have the same strict capital and other regulatory restrictions as conventional banks. 35 Investment funds do not have the same financial structure as banks: the funds are owned by the pool of investors and managed as a pool. Fund managers charge fees which can be fixed or variable. Returns can vary depending on type of assets held by a fund (interest, dividends, commodity prices, capital gains, and exchange rates, among others), but distributions to investors will often be in the form of dividends. Repayment of capital contributions and earning is not a capital-certain liability, unlike the deposit and accrued interest liabilities of conventional banks. The classification of investment funds as MMMFs or other investment funds is based on assets and financial flow characteristics of each fund. Data must be collected on each fund for this purpose. (a) Money market mutual funds MMMFs are a specific type of investment fund with monetary characteristics that justify their

36 22 classification as a separate subsector. A survey undertaken for the IFSB concluded that about one third of known Islamic investment funds are money market funds, often established to provide a capital-certain harbour for placement of Islamic funds. A high degree of capital certainty is a key feature of MMMFs, based on a strategy of the fund of investing in liquid instruments with nearly constant value. Funds without a high degree of capital certainty are not classified as MMMFs. 36 MMMFs are considered monetary institutions because they meet several characteristics, as follows: similar to transferrable deposits or money market instruments. (b) Other investment funds This subsector includes all Islamic investment funds other than MMMFs. Other investment funds could be common in Islamic finance with its emphasis on investment in trading, commercial ventures, project development, and real estate, among others. Islamic investment funds must follow sharia investment standards and could invest directly in sharia-compliant ventures or purchase sukuks or other Islamic financial instruments. Provide fund shares similar to bank deposits that the public treats as deposit substitutes; O protection of the asset value of the shares; Offer interest-like returns similar to deposits (Islamic MMMFs typically provide unremunerated capital-certain accounts similar to zero-interest current accounts at conventional banks); Some offer transferrable deposits usable for payments to third parties; Funds might be available immediately, such as with sight deposits. Islamic investment funds can be classified as MMMFs if the following applies: indicative returns (returns indicated by Islamic banks as likely but not guaranteed) are similar to conventional deposit rates; they offer investors high liquidity; and they have smoothed distributions to IAHs with rates separate entities and not consolidated into the financial accounts of their managing Islamic bank. 37 Sharia-compliant hedge funds should be recorded in this subsector. Hedge funds are a special type of investment fund limited to sophisticated investors, and usually not subject to strict regulation because of that limitation. They invest in a wide range of assets, but tend volatile price movements. Other financial intermediaries catchall category of types of financial intermediaries, including Islamic firms, not otherwise enumerated (enumerated firms include ODCs, insurance firms, pension funds, financial captives, and financial auxiliaries). Many different types of OFIs exist that provide a diverse range of financial instruments or services, some for

37 23 specialized niche markets SNA narrowed the definition of this subsector by reclassifying some units into new subsectors for MMMFs, other investment funds, and captive financial intermediaries (including money lenders). In contrast to ODCs that receive a certain portion of their funding from deposits that are part of broad money, OFIs receive funding from long-term or specialized deposits not part of broad money, securities, equity investments or shares, and funds provided by parents. of the group they owned. For bank holding companies, this change moves the SNA treatment away from the Basel supervisory consolidation that includes bank holding companies within the consolidation for capital adequacy purposes, because the parent holding company parent bears entrepreneurial risk for the banking group. Whether the new SNA treatment is applied to any Islamic bank holding companies is unknown, but this structure might be suitable for cross-border holdings of Islamic financial units. Common types of OFIs are investment banks, finance companies, financial leasing companies, specialized financial intermediaries such as factors or export finance companies, securities underwriters and dealers, venture capital firms, pawn shops and e-money corporations. Centralized clearing houses that take intervening positions in over-the-counter derivatives transactions are explicitly defined as financial intermediaries classified as OFIs. Among Islamic OFI categories are finance companies that provide murabahah or bai alajel instalment sales, and investment banks or leasing companies that provide longer-term construction, istisna, or ijara financing funded through sukuks or longer-term deposits. Hajj funds that receive long-term deposits to finance future trips are OFIs. Head offices. In contrast to holding companies, head offices actively manage units under their ownership or control. Head offices therefore produce services that should be recognized in SNA and allocated according to the principal activities of the group; they could therefore be classified within any of the financial subsectors. This structure might be suitable for cross-border holdings of Islamic financial units. As per 2008 SNA, a head office managing a mix of financial corporations should be classified as a financial auxiliary, but the present paper recommends that, whenever feasible, they should be classified within specific financial subsectors, most importantly for banking or insurance. Head offices could have substantial own financial assets, and metadata should note how they are classified. Holding companies SNA changed the treatment of holding companies to classify as OFI companies that only hold financial assets and do not exercise management control over subsidiaries. Prior to that, holding companies were classified according to the main activities Insurance This subsector includes corporations, quasicorporations, and mutual organizations that provide life, accident, health, fire and other insurance services. 38 Insurance companies take

38 24 premium payments from policyholders and agree to make benefits payments when an insured event occurs. Islamic insurance (takaful), which is growing fairly rapidly in some countries, is included in this subsector. Reinsurance companies (retakaful) and exchanges that insure the risks of other insurance companies are also included SNA also includes standardized loan guarantees as a form of non-life insurance to cover expected defaults in a portfolio. It is unknown whether any standardized loan guarantee units exist in Islamic finance. Pension funds Pension funds provide benefits for retirement or disability. Pensions can be offered by separately organized firms or by employers. This subsector, meaning that they are separate from the unit - classified as part of the employer who created them. For example, social security pension plans are part of the Government. The finances of pension funds parallel those of life insurance companies, receiving funds to build reserves to make payments for future claims. As per 2008 SNA, an enforceable pension liability exists even if it has not been funded. As enforceable contracts, pensions are assets of households and liabilities of the pension fund or employer offering the pension. Islamic pension funds are classified in this subsector, with many integrated into takaful companies. Currently, there are relatively few Islamic pension funds, partly because of a limited pool of long-term sharia-compliant investments, such as in sukuks or shares of companies engaged fully in sharia-compliant activities. However, several countries are working to build markets for the types of assets that can support growth of Islamic pension funds. Captive financial institutions and money lenders 2008 SNA expands the definition of the financial sector to cover units that provide financial entity or closely related group of companies. Captives do not have market-based transactions with their parent; only their assets or liabilities are transacted with their parent. Prior to this, financial arms of parent corporations were called ancillary corporations and consolidated into the parent corporation, including into nonfinancial corporations. In the new definition, financial arms that operate as separate entities, including in foreign countries, can be classified within the financial sector. Units that can be treated as captives include: trusts, estates and brass plate companies; holding companies as defined in 2008 SNA; SPVs (structured entities) that raise funds for their parent in open markets; money lenders; pawn shops; and firms lending funds received from a sponsor such as the Government or a non-profit institution. SPVs are of special interest in this group SNA defines SPVs as financial entities without employees or non-financial assets owned by or affiliated with other units, and which are often

39 25 set up in different countries for tax or legal reasons. SPVs have been used to securitize bundling assets with derivatives or guarantees, or shift insurance or reinsurance obligations. An SPV potentially relevant for Islamic finance -compliant financing by issuing securities to fund purchase of the financings. Moreover, a type of Islamic financial unit that might fall into this classification is separate financing arms set up in offshore centres or international finance centres to issue sukuks in the name of their parent. SPVs have also been set up in conjunction with sovereign or official infrastructure sukuks, but they should be classified as separate financial captive units only if they are effectively separate from their parent. Money lenders, which are important in many developing countries, could provide shariacompliant funds. It has not yet been decided whether sovereign wealth funds funded by Governments, central banks, or extractive industries are to hold and invest financial assets, including sharia-compliant assets, since future beneficiaries are separate entities that can be treated as financial captives. Financial auxiliaries Financial auxiliaries are units that are not directly engaged in financial intermediation, but which provide closely related services. Many are financial infrastructure companies including brokerages, exchanges, clearing houses, securities depositories, collateral agents, and asset management companies resolving financial crisis situations. Non-profit institutions serving the financial sector are classified here. Several countries (including some non-muslim countries) are seeking to establish themselves as centres for Islamic finance, either as part of their general financial markets or in separately established international financial centres. Financial infrastructure specifically designed for Islamic financial instruments (exchanges, depositories and credit bureaus, among others) set up in such centres should be classified here. However, units that act as intermediaries (such as centralized clearing houses that take intervening positions in over-the-counter derivatives) are not financial auxiliaries and should be classified in other financial subsectors. Structural indicators of Islamic banking In sharp contrast to the decades-long compilation of national accounts and monetary statistics data on conventional banks, systematic compilation of statistics on Islamic banking is only a few years old and is still evolving. Data were previously unavailable because Islamic banks where indistinguishably intermixed within data covering the entire banking sector. In 2014, IFSB, headquartered in Kuala Lumpur, began compiling PSIFIs that cover the following: 39

40 26 Prudential Islamic Financial Indicators (PIFIs) are measures of the strengths or vulnerabilities of Islamic banking systems (as opposed to individual banks). PIFIs are mostly supervisory ratios 40 that largely parallel the IMF FSIs but with customization to the specific instruments and methods used in Islamic finance. PIFIs and FSIs generally have a financial supervisory focus and apply some concepts (definitions of capital, liquidity, statistical consolidations, residency, and others) that differ from those used in SNA; Structural indicators that cover the size and structure of the Islamic banking sector, including balance sheet, income statements, and types of financial instruments used by Islamic banks to fund themselves and extend financing. These data track the growth of Islamic banking and its evolution. Such data often draw on features of the SNA. Box 3. Structural indicators for Islamic banks Number of Islamic banks Number of domestic branch offices Number of automated teller machines (ATMs) Number of employees Total assets Total sharia-compliant financing (excluding interbank financing) Sukuk holdings Other sharia-compliant securities Interbank financing All other assets Total funding/liabilities and equities Profit-sharing investment accounts (PSIAs) Other remunerative funding (murabahah, commodity murabahah, and more) Non-remunerative funding (current account and wadiah) Sukuk issued Other sharia-compliant securities issued Interbank funding/liabilities All other liabilities Capital and reserves Total revenues Financing-based Investment-based (sukuk, other sharia-compliant securities, and more) Fee-based Other Earnings before taxes and zakat Value (or percentage) of financing by type of sharia-compliant contract In addition, the Structural Islamic Financial Indicator (SIFI) ratios provide some supplementary data about the structure of Islamic banks and their funding and financing patterns. The data include: net income, operating costs, shariacompliant financing by the International Standard Industrial Classification of All Economic Activities (ISIC) code, nonperforming financing, non-performing financing by ISIC code, provisions for non-performing financing, foreign exchange funding and financing, returns by type of sharia-compliant financing, and income distributed to investment account holders (IAHs). Source: Islamic Financial Services Board, Compilation Guide on Prudential and Structural Indicators for Islamic Financial Institutions, 2017.

41 27 Both PIFIs and SIFIs are separately compiled for Islamic banks and for Islamic windows of conventional banks (which are treated like institutional units deconsolidated from their parent bank). However, in some cases, the windows data is not available or incomplete. As seen in box 3, structural data covers basic information about the size and structure of the Islamic banking sector. This data is sufficient to understand the development of the sector and its role within the banking system of a country. Furthermore, by translating structural data into a common currency (US dollars or special drawing rights, for instance), data for countries can be added to estimate the global size and growth of Islamic banking. Structural indicators are based on financial accounts data, such as balance sheets or income statements, such as those used for compilation of national accounts statistics. As such, there is potential to compare the Islamic banking sector against the full national banking sector, or make direct comparisons by constructing separate peer groups for Islamic banks and conventional banks. Complicating such comparisons is that IFSB data use a supervisory consolidation that can be cross-country, in contrast to the domestic consolidation used by SNA. However, at this point, because most Islamic banks operate only they are de facto on the SNA domestic consolidation basis, and thus direct comparisons (and aggregation to national totals) are feasible. There are exceptions, and multi-country Islamic banking organizations will increase in the future, which might ultimately require a shift to formally adopt the SNA type consolidation, but in most countries with Islamic banking that step is not yet needed. IFSB has just begun collecting full balance sheets and income statements for the Islamic banking systems, following the practice of the FSI programme of IMF. The statements themselves will be diverse because countries follow different accounting standards (IFRS, national generally-accepted accounting principles and AAOIFI, each at different stages of adoption), which is an endemic problem in compiling data on Islamic banking. However, the detailed accounts within each country will provide a good presentation of the structure of the sector, and provide a basis for systematic extraction of information usable in SNA. Over time, it is hoped that the IMF monetary statistics and FSI data sets will compile separate peer group data for Islamic banks in view of their material differences from conventional banks and increased systemic importance in many countries. Conclusion The present paper provides insight into how to represent Islamic banking within SNA. Islamic banking has grown rapidly over the past two decades, and it is time to address how SNA should handle its unique features. Without specific compilation guidance, countries are, for

42 28 the most part, treating Islamic banks as if they were conventional banks, creating dangers of biased results and lack of comparability between countries. Information on important structural features of the financial systems of many emerging and developing countries is not being compiled. The paper explores how several Islamic banking activities might be treated in SNA. The topics are complex, and the following actions can be undertaken to move forward: Information on national practices in compiling statistics on Islamic banks should be gathered. This can guide future research, reveal gaps, identify feasible approaches, and build a database of what is known about Islamic banking. This information will also support future consultations and institutionbuilding efforts of IMF, World Bank, Islamic Development Bank and regional organizations, such as the Statistical Centre of the Gulf Cooperation Council (GCC) for the Arab Gulf States; To support development of high-quality, internationally comparable statistical systems, and support their oversight functions, IMF, Gulf Monetary Council and GCC-STAT can initiate statistical methodology work on Islamic banking and finance. IFSB has a similar role to play in enhancing the quality and comparability of its structural indicators; More work is needed to standardize the names of Islamic financial instruments and define their economic flows. IFSB has advanced this work in conjunction with its PSIFI data collection. The Malaysian Financial Reporting Standards use an instrument-by-instrument approach to construct financial reports that might be useful. Regional bodies (GCC, the Arab Committee on Banking Supervision, and others) should promote such standardization to facilitate their oversight. However, since countries use different instruments (or similar instruments with different names), this part of the process is likely to be lengthy and painstaking; Work should be forward-looking to consider the development of frameworks for non-bank Islamic financial institutions and Islamic securities markets. IFSB is again in the lead in such work. Among non-bank institutions, insurance (takaful) is a priority. Given the participatory nature of funding of Islamic financial institutions, the line between banking and investment funds is blurry. Coverage of securities markets should be a priority in the European Union and financial centres, such as Kuala Lumpur, Hong Kong, Luxembourg, Singapore, and Dubai; Statistical coverage of financial inclusion (microfinance) deserves a special initiative in light of its direct impact on millions of people; The United Nations must continue working on its project on Islamic finance in national accounts, for which the 2017 workshop in Beirut was a critical foundation step; Statistical work must be dovetailed with the rapidly increasing work at IMF, the Bank for International Settlements and elsewhere on the role of Islamic finance in policy, surveillance and financial stability. Much of this work relates to financial stability analysis and supervisory needs, or granular analysis of microdata and systemic importance of

43 29 individual institutions, but many interactions can be expected between statistical requirements in these areas and the macroeconomic statistical work for national accounts; The International Association for Research in Income and Wealth should promote this frontier methodology work. Bibliography Islamic Financial Services Board (2010). Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders. Available from 3_Guidance_Note_on_the_Practice_of_Smoothing.pdf. (2011). Revised Compilation Guide on Prudential and Structural Islamic Financial Indicators. Available from 23%20PSIFI%20Compilation%20Guide%20(Final%20Clean).pdf. (2016). Islamic Financial Services Industry: Stability Report Available from Sundararajan, V. (2006). Risk measurement and disclosure in Islamic finance and the implications of profit sharing investment accounts. Paper presented at the Sixth International Conference on Islamic Economics Banking and Finance, Jakarta, November. Available from

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45 31 Paper Two A Review and Treatment of Islamic Versus Conventional Bank Products in National Accounts by Ragheed Al Moghrabi Financial expert and Professor at Rafik Hariri University rmoghrabi@protonmail.com Omar Hakouz Regional advisor on National Accounts, ESCWA Statistics Division hakouz@un.org Wafa Aboul Hosn Chief, Economic Statistics Section, ESCWA Statistics Division aboulhosn@un.org

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47 33 Abstract The present paper explores the field of Islamic finance and its product offerings, as they are accounted for and measured within the existing System of National Accounts (SNA). A comparison between traditional banks and Islamic finance entities (IFEs) and their product particularities is introduced at the outset. The paper subsequently explores the application of national accounts measurement and recording as pertains to Islamic finance, and uses product examples in critiquing methodology and conclusions. The discussion parameters of the issues take into consideration risk matters, treatment of accounting, and a cost-benefit framework for outlining the debate, with a view towards the resolution of outstanding issues. Background on differences in traditional versus Islamic platforms The historic foundation of our financial system, and banking in particular, is based upon the movement of funds from savings surplus units (SSU) to savings deficit units (SDU) in the economy. This function is critical in facilitating the intermediation process between saver and investor, with implications on our financial lives. In dealing with financial institutions, customers interact with front-line representatives who use financial products as tools in the intermediation process with the ultimate aim of providing timely solutions while keeping an eye on the need to innovate. There is a broad consensus in the service-marketing literature to classify services using different criteria, such as how a service can be customized for the customer or how the serv competitive marketplace for financial and banking solutions has created an environment with a universe of product offerings with everincreasing sophistication, across type of product, geography and size/scope of the institutional product provider. Within financial services, there is a challenge in evaluating them as they are offered through a range of delivery systems. The same product can be developed by two entities, and they are generally acquired as a means of achieving an end. As shown in figure 1 below, Islamic financial institutions can be broadly classified into four categories in terms of approaches of financing that can satisfy particular financial needs of customers, namely, deposit products, credit products, capital market products, and insurance products. Much as is the case in traditional banking systems, the supervision mandate of the central bank has, at the outset, a stability remit of the financial system as a whole. Moreover, the ethical conduct of employees working for

48 34 member institutions is of paramount importance. It is a given that central banks issue banking charters for startup institutions that offer traditional products or services, but that charter-issuing role extends to Islamic finance and banking as well. Going forward, the regulator undertakes a supervisory and regulatory function regarding Islamic institutions identical to regarding a conventional institution. As concerns the implementation of prudential supervision, although Islamic banking is largely based on profit-and-loss sharing agreements, sharia-compliant institutions still need to be supervised at the same level as conventional banks. In fact, as already pointed out by Errico and Farrahbaksh and El Hawary and others (2004), there are certain features of Islamic banks that warrant prudential regulation to a similar degree as traditional banks, including the following: With risks come mitigation efforts through Islamic banks focused on maintaining their market share and minimizing the losses passed on to customers. Another tool used is the investment risk reserve to protect depositors from certain risks. This is to be considered when classifying investment deposits in Islamic banks as deposits or shares; Safeguarding the interests of demand depositors: Demand depositors in Islamic banks, also known as current account holders in conventional institutions, face the same risks as demand depositors in conventional banks and thus merit the same level of protection; Systemic considerations: While the failure of a corporation would not have contagion effects, the failure of a bank could result in Moral hazard considerations: Within Islamic financial institutions, the critical element of risk sharing applies to investment deposits. The agreement is that depositors place funds in activities the bank invests in and views as profitable. However, sharia-compliant institutions, in their role of sharing a potential investments loss, could, by their nature, include riskier projects versus guaranteed deposits in conventional banks. Investment depositors also require greater guarantees than company shareholders as Islamic banks take on high leverage given the presence of demand deposits; and risk associated with leverage has been a historic concern. In addition, investment depositors do not have equity voting rights as customers, they do not have an associated of the banking system as a whole, thus triggering a generalized bank run; Sharia compliance: Supervisors must have an understanding of whether the activities of some countries, private Islamic banks have their own sharia advisors. However, setting up a sharia consultative board at the supervisory agency would be beneficial in countries where Islamic banks are present. Central banks would need to recognize the need for this evolution in their relationship with member institutions to take actions. The spread of Islamic finance in an increasing number of countries has hastened the need for a set of internationally accepted regulations. To satisfy this need, the Islamic Financial Services Board (IFSB) was created

49 35 in 2002, with a mandate to develop prudential and regulatory standards for the Islamic industry, and to identify and publicize recognized international best practices in several areas. Paralleling the development of the Basel II Capital Accord, IFSB issued regulatory standards on capital adequacy and risk management for Islamic institutions. The scope of IFSB guidelines encompasses critical matters such as corporate governance and the supervisory review. Figure 1. Categories of Islamic financial products (IFPs) Source: Islamic Financial Services Board, Understanding the nature and market for Islamic financial products, Asian Journal of Business Research, 2015.

50 36 Figure 2. Categories of traditional bank products Current account Traditional bank products Deposits Business Savings account Insurance Loans Fixed deposit Personal Brokerage Mortgage Investments Home equity Individuals Auto Against securities Credit card Source: Prepared by author. Funding source differences between traditional banks and Islamic finance entities and the impact on businesses The broad difference between conventional retail banks and their Islamic counterparts is that the former perform their funding operations through interestfunding is executed via Islamic modes of financing. Viewed from the balance sheet perspective, this basic operation leads to the financings offered to retail bank clients. The balance sheet of a retail bank, like that of most companies, consists of a broad range of liabilities and assets with a range of liquidity. In essence, the first function of a retail bank is to attract liabilities in the form of deposits and utilize them to create assets in the form of financings to bank clients (or more commonly banking is therefore a sensitive issue because the ability to provide finance depends on the nature and stability of deposited money. In this domain, the regulator must maintain vigilance

51 37 exposure to retail banking balance sheet risks. Two methods are used, namely, the allocation of sufficient cash reserves against the deposited funds; and avoidance of unnecessary risks in the financing activity. Within Islamic banking, the mission becomes to avoid involvement in risky economic enterprises thus protecting depositor funds by utilizing low-risk modes of finance such as murabahah and ijarah. Deposit accounts of Islamic retail banks are broadly classified into two categories, namely, demand deposits, also called current accounts, and Islamic investment deposits or profit-andloss-sharing (PLS) investment accounts. Table 1. Definitions of financial products in Islamic finance Financial products Mudarabah Musharakah Murabahah Ijarah Al Istisnaa Bai al salam Qard hasan Sukuk Characteristics A contract in which one of the parties (the possessing of capital appointed rab al mal) provides the capital to another party (the contractor appointed mudharib) which ensures the necessary work to use these funds. A contract for the participation of two or more parties in the capital and the management of the same case. It is a partnership with allocation of losses and profits. A contract of purchase and resale with a profit margin prefixed in advance; in other words, the bank buys from a supplier a tangible property at the request of its client, the well is resold to the customer at a price equal to the cost of purchase plus margin. A leasing contract or lease by which a bank buys a well for the completion of a project and gives the rent to a company for an amount and a maturity agreed. A contract that brings together the oustasnii (investor) and the sanii (contractor/manufacturer) for the execution of a property for a fee payable in advance. The two parties will agree on the price and the time of delivery. A technique to pay in advance goods that are predetermined. The financial institution pays the price of the asset in advance for a delivery date deferred. A loan without interest often supported by a guarantee, granted by the bank to its customers in order to cope with specific circumstances (such as death, marriage, child care, and education). An Islamic commitment backed by a tangible asset. It indicates a right of debt during a specified period and is attached to investment funds with predefined risk and yields assistance. Source: Sirine Gha and Nejia Nekaa, Efficiency of Islamic financial institutions, Journal of Business and Management Sciences, vol. 4, No. 4, 2016, pp

52 38 1. Current accounts Current accounts satisfy the following two main conditions: they promise no return to the principal amount; and they can be totally withdrawn at any time without notice, or From an Islamic perspective, the taking of demand deposits is equivalent to borrowing funds from depositors, while withdrawal is equivalent to repayment of borrowed funds. The borrowing of funds is permitted in sharia so long as it is an interest-free loan with the promise that there is no reward to the lender. In exchange for the privilege of using an interestfree loan, it is important that an Islamic bank, as the borrower, guarantees repayment of the loan to the lender, but not necessarily the return. This is crucial according to sharia authorities as a criterion for distinguishing between the concept of qard (repayable loan) and that of amana (trustable fund). The former creates what yad dhaman) on the borrowed funds, while the latter creates a yad amana). In other words, the borrower is obliged to repay the qard under all circumstances unless the lender relieves him of this obligation, but no such obligation arises in the case of amana. Repayment of amana is done on a best-effort basis and can only be guaranteed in case of gross negligence. Hence, current accounts in Islamic banks follow the rules of qard in Islamic jurisprudence, which promises no return to the depositor while holding the bank accountable to repay the deposited funds at any time. When an institution includes checking facilities as an offering, this does not impact the legitimacy of current accounts as long as banks provide depositors with cheque books to control the inflows and outflows of their accounts. Conventional banks provide the same current accounts accommodation, but in many cases tend to contravene the Islamic rules of qard. In effect, it is not unusual for conventional banks to promise promotional gifts to open an account, given the keen competition among rival banks to attract new depositors. Moreover, it is a typical practice of conventional banks to offer overdraft facilities with which current account depositors may draw more amounts in excess to what they have deposited. The issue with this approach in the eyes of Islamic scholars arises from the switching of the roles of lender and borrower between bank and client: the bank becomes a lender and the client becomes a borrower. Effectively, the violation relates to the charging of a positive interest rate by banks as lenders, and is strictly prohibited in sharia. This issue should be taken into account when classifying current accounts, as it may affect issues related to money supply. 2. Investment accounts Investment accounts are the Islamic alternative to the interest-bearing term deposit accounts in conventional banks. Like term deposits, Islamic investment accounts are held for specific periods of time by banks and hence cannot be drawn on demand, without prior notice. However, unlike conventional term deposits, Islamic investment accounts avoid the use of interest rates both in the compensation of account holders and in the utilization of funds. Two primary issues are therefore raised by Islamic investment accounts. As a matter of practice, holders of Islamic investment accounts

53 39 can only be compensated from profits as actually realized by the Islamic bank; therefore, depositors are not promised any positive returns on their funds, whether predetermined or floating. at this from a national accounting perspective, a question might arise regarding the classification of the investment deposits under deposits or shares, and the effect this can have on income flows. There are two types of investment accounts in Islamic banks, which are the following: (b) Restricted investment: offbalance sheet accounts (a) Unrestricted investment: balance sheet accounts The first option gives rise to a PLS concept. In short, the PLS investment account underlines an unrestricted mudarabah contract between the bank and depositors allowing for the mixing of upon a musharakah contract whereby the bank acts as a partner (sharik) as well as a manager of the funds, given that all the other partners (the investors) have given up their right of management to the bank. In both cases, the parties may share between themselves whatever profit or loss happens to be generated from the utilization of deposited funds, as long as it adheres to the PLS ratio. Generating profits in unrestricted investment accounts means that assets are created by extending financing facilities to other client activities. At the outset, it is understood to what extent PLS investment accounts are also utilized by the bank to generate profits, and the account holders are entitled to a share in such profits. This explains why PLS accounts are balance sheet accounts. Unrestricted PLS accounts are accessible to all potential depositors who wish to share in the overall profitability of the Islamic bank, subject to terms and conditions, which impose no restrictions on the utilization of funds by Islamic banks apart from sharia compliance. By looking The other two options of accepting investors deposits restricted mudarabah and agency contracts have one thing in common: they restricted investment, where the investor wishes to generate profit from a specific field of economic activity rather than share in the overall profitability of the bank. It is therefore an off balance sheet investment account as the bank does not mix such funds with the pool of funds invested on an unrestricted basis (such as current accounts, investment accounts and funds). It simply reduces the the case in unrestricted investments, the depositor cannot be guaranteed any returns. Mudarabah is adopted for the management of restricted investments, where the depositor assumes the position of rabb al-mal, while the Islamic bank assumes the position of mudarib. In this case, share in the profit that can be realized from the management of the investment. However, if loss is realized at the end of the contract, it will be borne by the holder of the restricted account alone, and the bank will only lose its administrative effort. Alternatively, the bank might a management of restricted investment accounts (working for an agency fee that can be a fixed amount or defined as a percentage of the

54 40 denominated in a fixed amount at the outset of the agency). The agent is bound to work on a best-efforts basis but cannot guarantee any return to the investor, per Islamic finance rules. This is an important point to recall as it is against conventional practice where the agent is held to account and must reimburse the principal against all damages. 3. Assets generated by variable return modes Assets generated through mudarabah and musharakah contracts would usually have the following attributes: (a) only be generated from the operations of the projects being financed. Accordingly, the financing decision requires a careful economic feasibility study of the prospective projects to assess their potential profitability. This is an internal self-initiated method of risk management. Accordingly, the types and characteristics of services provided by Islamic banks are different from the services provided by conventional banks since they do not conduct feasibility studies and assessment related to the projects to be financed; (b) The financed client is committed to a best effort policy that is translatable into clear contractual terms, but otherwise the client cannot guarantee return or principal to the Islamic bank; (c) The financings is often based on an expected rate of return of a relevant project to be financed. This expected rate of return proves useful in assessing the expected performance of the project, even though it cannot be guaranteed; (d) To guard against the possibility of loss that misconduct, it is permissible to take collateral from the financed clients. This is the only situation in which the client would be held liable to guarantee principal in mudarabah and musharakah financings. 4. Assets generated from fixed return modes Assets created from fixed return modes share the regular property of having an organized, structured and dependable future income, based on the fixed price in sale contracts, in addition to the following: (a) Unlike mudarabah and musharakah assets, it is currently mandatory for a customer to pay the scheduled instalments. Consequently, the Islamic bank can take securities or collateral from customers to ensure timely payment of instalments; (b) Islamic bank loans are not considered variable rate loans, unlike their tranditional counterparts. In other words, Shariacompliant financing does not rely on interest rate indexes determined by central banks and market forces to adjust the rates charged to consumers; (c) This standard is based on the use of historical cost as opposed to current market prices in the valuation of Islamic banking assets. It is a generally accepted accounting principle according to Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards;

55 41 (d) Cash flows stemming from murabahah contracts are special forms of pure receivable debt arising from the sale of real goods against agreed deferred payments (instalments). Having sold the goods, the bank will have no recourse but to revise the agreed instalments or to penalize defaulted clients, much like conventional banks, by charging additional interest. Of particular use is the ijarah, which provides a particular flexibility since the bank continues ownership of the physical asset (real property or equipment) and gives it a special recourse to revise the terms of the ijarah contract (in response to any external economic shocks). Ijarah is useful for long-term financing, but also for the structuring of open-ended mutual funds where investment fund units can be bought and sold among potential investors. Istisna and salam assets are the Islamic counterparts of conventional futures. However, unlike conventional futures, which are extensively used in pure speculative trade, the Islamic counterparts address the financing needs of clients at particular periods of time and therefore might be mistakenly perceived as subject matter of speculative trade. Risk of specific products versus issues such as tenor and liquidity To better understand the structure of Islamic financial institutions and their conventional rivals, we can review some data from Gulf Cooperation Council (GCC) countries. The analysis for the purpose of the present study was carried out using annual banking data from Bankscope for GCC countries over the period , based on 65 banks (38 conventional and 27 Islamic). The sample did not distinguish versus retail). Table 1 shows that the reliance of Islamic banks on deposits has increased recently, with data provided through For Islamic banks, the average deposits-toassets ratio was 62.3 per cent over the period , but not significantly different from the conventional banks ratio of about 64.1 per cent. A build-up was particularly noticeable in Results indicate that conventional banks, on average, performed better after the 2008 crisis than their Islamic counterparts (table 2). With few exceptions, Islamic banks in most GCC markets seemed to have lower access to securities. While, on average, Islamic banks recorded slightly lower non-performing loan (NPL) ratios in terms of gross loans than in conventional banks, the gap in NPLs has contracted since Islamic banks recorded, on average, lower profitability than their conventional counterparts. The difference in profitability is explained, in part, by higher holdings of liquid assets and property investments by Islamic banks. This difference in asset allocations partially reflects limited investment opportunities available to this banking segment.

56 42 Table 2. GCC countries: Conventional and Islamic banks, average for (% of assets unless otherwise stated) Conventional banks Islamic banks Deposits Securiteies Liquid assets Non performing loans Return on assets Return on equity Source: Bankscope and IMF calculations. Note:. 1 For Saudi Arabia, total security holdings are significantly higher than conventional banks. 2 Percentage of gross loans. 3 Percentage of equity. Limits of monetary policy tools According to an International Monetary Fund (IMF) survey conducted in 2011, shariacompliant central bank facilities are limited, reflecting the difficulty in designing marketbased instruments for monetary control and government financing that satisfy the Islamic prohibition on future interest payments. The 2013 Islamic Financial Services Board (IFSB) assessment also corroborated this view (figure 3). Most central banks do not provide deposit or credit facilities for Islamic Financial Services Industries (IFSIs) that are sharia-compliant. Despite significant progress in Islamic banking infrastructure, access to market financing (particularly to securities and other placement opportunities) remains limited for Islamic banks when compared with their conventional counterparts. This is creating market segmentation vis-à-vis conventional banks in an environment where banking consolidation is used to strengthen Islamic bank competitiveness in some countries. These findings are consistent with the results of other studies. Figure 3. Tools for monetary operations of central banks Source: Islamic Financial Services Board, 2013.